Efficient Market Hypothesis (EMH)

Question 1

What are the three forms of the hypothesis?

Answer 1

1. Weak form
2. Semi-strong form
3. Strong form

Question 2

What does the EMH states?

Answer 2

It is difficult or impossible to beat the stock market. (It is not possible to beat the market except by luck in the strong form).

Question 3

Describe the weak form.

Answer 3

Prices reflect information contained in the PAST PRICES.

Question 4

Describe the semi-strong form.

Answer 4

Prices reflect infirmation contained in the PAST PRICES and in the PUBLICLY AVAILABLE INFORMATION.

Question 5

Describe the strong form.

Answer 5

Prices reflect infirmation contained in the PAST PRICES, in the PUBLICLY AVAILABLE INFORMATION and prices reflect PRIVATE INFORMATION.

Question 6

What does the EMH says if a surprise occurs?

Answer 6

The stock price will immediately reflect the surprise, so it will be impossible to profit based on it.

Question 7

What are the implication of EMH

Answer 7

1. Investors buy shares at fair price even if they don’t have information about the company.
2. Companies do NOT increase their value with accounting tricks.
3. Companies can ONLY gain value by investing in positive NVP projects.
4. Financing positive-NPV projects by selling equity will not lower the value of the company.
5. Investors can generate positive-NPV only if there are barriers to trade OR if an investor has a UNIQUE possibility

Question 8

What are the evidence for weak form efficiency?

Answer 8

1. Kendall : stock prices appear to follow a random walk
2. BMA : scatter plot for price change - no patterns
3. PS: variance of multi-period change is approximately proportional to number of periods.

Question 9

What are the evidence for semi-strong form efficiency?

Answer 9

KP analyzed the stocks return in the presence of a takeover : found some price increase because of leakage, then a one time increase at the time of the announcement and no abnormal return afterwards.

Question 10

What are the evidence for strong form efficiency?

Answer 10

Most mutual funds underperform the market : professional can’t beat the market.

Question 11

Name and explain the CALENDAR/TIME market anomalies.

Answer 11

1. January effect: returns are HIGHER in Jan, lower in Dec
2. Monday effect: returns are LOWER on Monday, higher on Friday
3. Time-of-day effect: returns are more volatile at market OPENING and CLOSING time

Question 12

Name and explain the REACTION TO INFORMATION market anomalies.

Answer 12

1. IPOs have higher returns on the first day (OVERREACTION), but underperform over the 3-5 year period after issue.
2. Stock of firms with unexpected good returns out perform stocks of firms with unexpected bas returns over a period of 6 months following announcement. (UNDER REACTION)
3. Momentum effect: positive returns followed by positive returns (UNDER REACTION)
4. 1 Mean-reversion effect: positive returns followed by negative returns (OVERREACTION)

Question 13

Name 5 other market anomalies (not related to calendar, time or reaction to information).

Answer 13

1. Siamese twins: two stocks with claims on same CF do not trade at same price.
2. Political cycle: first and last year of political administration have BETTER returns
3. Stock split effect: when a stock splits, it has a higher return both before and after the split announcement.
4. Neglected firms: Small firms have higher returns
5. Super Bowl effect : When the winning team is from the AFC, market do WORSE than when it is from the NFC

Question 14

Are bubbles market anomalies?

Answer 14

No, but they are an example of market INEFFICIENCY.

Question 15

Name 3 bubbles in the last 30-35 years.

Answer 15

1. Japanese stock and real estate bubble
2. Technologie (dot.com) bubble
3. U.S housing bubble